Bitcoin and Blockchain Demystified

December 21st, 2017 Mike

Bitcoin is all the rage these days. And, so is Blockchain. What’s it all about?

Bitcoin is a cryptocurrency. This means that it is a medium of exchange, just like money except that it’s all in electronic or “soft” form on the internet. There are really no physical coins involved. In essence, Bitcoin is a currency without a country associated with it. It could be regarded as an international peer-to-peer payment or money transfer system that does not need to rely on a trusted third party. Much like physical dollars, a cryptocurrency such as Bitcoin has no personal identity associated with it. It is totally anonymous.

Instead of holding physical dollars, Bitcoin holders hold “addresses”. These addresses are analogous to bank account numbers. In the same way that you can see someone’s bank account number by looking at the numbers on the bottom of cheques, these addresses are highly visible. Addresses are derived from Public Keys but only their owners can access them using a Private Key (like a special password). There is no limit on how many addresses you can have. Many people use several addresses. In fact, the use of a new address for each transaction is often suggested. Addresses are generated by the software that resides on websites or electronic wallets (see below for more on wallets). An address for the Bitcoin Blockchain consists of 27-34 alphanumeric characters allowing an almost unlimited number of addresses. These are what you usually see on transaction reports. To illustrate, one of my addresses for bitcoin is: 1PbhcxAD9Kn2m4UM71PBAmtEuU2kBCg6Ky. If you enter this (try it!) in the search box at www.blockchain.info, you will see information about transactions and a final balance – anyone can see this. A cool, graphical way to look at transactions is by clicking on one of the transactions and then clicking on “view tree chart” on www.blockchain.info in order to visually follow the transactions. On the same website you can look at every single Bitcoin transaction that ever took place, albeit without knowing who owns the addresses (i.e. accounts) – something you can’t do with a bank’s accounts. Because I told you that I own the above address, you could use it to send me some bitcoin. It will show up as coming from another address but I won’t know that it’s from you unless you tell me.

It’s worth noting that someone can steal your bitcoins if they know your private key. When processed with bitcoin software (technically called “hashing”), a private key will “unlock” its associated public key and produce the address. The reverse is not true. You can never generate the private key from a public key or address. That’s the beauty of cryptography.

Blockchain is the digital (i.e. electronic) record, i.e. the accounting ledger, where all of the transactions are stored. Each cryptocurrency has its own blockchain. So where is it? Unlike a bank where you have an account which you can access online to see your balance and make transactions (bill payments, deposits, etc), with Blockchain there is no bank. In other words, there is no specific control or authority over the accounts. Instead of accounts sitting on a bank’s server (i.e. computer), the blockchain records sit on thousands of computers, often referred to as nodes. The word blockchain is a good description of the accounting ledger: it is a bunch of blocks of transaction information that are chained together to make one large data file. As you can imagine, it’s a large file and continues to grow. In September, 2017 it was 135 GigaBytes (sounds big, but you can put that on a USB memory stick!). Think of blockchain as a technology insofar as there is a lot of software at work to make sure that the records are secure and can be relied upon.

To ensure integrity (so that no one can change the information) of the Blockchain, there is a process referred to as mining, also known as “proof-of-work”, which means validating the blockchain records. This is done by anyone who wishes to do so. All that’s needed is computing power (and cheap electricity to run the computers). The software has been designed (by many contributors) to allow the so-called miners to validate transactions and complete blocks that, once validated, are unalterable and then added to the chain. This process is very elegant and sophisticated and involves complex mathematical calculations. Miners don’t need to be mathematicians – they just need to plug in computers that are loaded with the blockchain software. Why would anyone want to be a miner? Miners get rewarded each time a block is completed by the issuance of some amount of Bitcoin. This is like printing money except that for Bitcoin, there is an asymptotic limit of 21 Million Bitcoins which will be reached in 2040. That’s a design feature. Today, approximately 17 million are in circulation. When that happens, there’ll likely be transaction fees to incentivize the miners (assuming Bitcoin survives). Over time, the payout to miners decreases as the limit approaches. Miners can be individuals or corporations. HIVE Blockchain is an example of a public company that has invested heavily in computer facilities in countries with cheap electricity. Miners compete with each other. Specific computer chips have been developed to speed up the processing. Only the miner who is first to validate and complete a block gets a bitcoin reward. The validation process takes approximately 10 minutes and currently pays the successful miner a reward of 12.5 bitcoins (worth about $250K at current valuations). A Chinese miner, Bitmain, reportedly made $100 million/year.

A currency issued by a country is known as a “Fiat currency” which means that it is not backed by a commodity asset such as gold as was the case with the U.S. dollar before 1971. A currency’s value, relative to other currencies, is determined by the demand for it by holders of other currencies. This is driven, for example, by trade and the relative prosperities of countries. Currencies can be exchanged, one for another, by banks, exchanges and various financial institutions. To do that, unless you exchange small amounts at an airport for example, you need an account with an institution where you have to identify yourself. Whereas the total number of Bitcoins that can ever be in circulation is limited, a fiat currency has no such limits. This scarcity attributes contributes to the buying frenzy for Bitcoin.

A cryptocurrency such as Bitcoin also has no intrinsic value. To buy or sell Bitcoin using a fiat currency, you need to exchange traditional money for Bitcoin using a Bitcoin exchange (examples: www.coinbase.com – one of the most common or www.canadianbitcoins.com or www.quadrigacx.com in Canada). After you receive Bitcoins, all of your cryptocurrency transactions will be anonymous. When you buy Bitcoin, you will be assigned one of the above-mentioned addresses that is automatically generated. You will also be given the key (password) to spend (ie transfer) Bitcoin from that address to another address. Should you lose this key, you will forever lose access to the Bitcoins you own. There is no bank you can phone to get a password reset! If you store this information on your laptop and your laptop is stolen, you will not only lose access but someone else can steal your Bitcoins. That’s why “wallets” were created. Wallets can be paper printouts (that you can keep in your safe) or password-protected files on your computer or wallets can be stored at a website that deals in cryptocurrencies. The latter choice can be dangerous. I had a small amount of Litecoin (another popular cryptocurrency) that I had stored in an on-line wallet at a site called www.btc-e.com. Recently, the FBI shut down that site (money laundering?) and now (maybe forever) I cannot access those coins. I can “see” them at an address but I cannot transfer them because I didn’t make a copy of my key. An early exchange known as Mt. Gox was also shutdown and people lost millions of dollars in value if they kept their keys only on the Mt. Gox website. A recent Globe & Mail article has a good summary of the more popular cryptocurrencies.

Buying a cryptocurrency is a hassle. It is far from an anonymous process (unless you go to a Bitcoin ATM). The exchanges – generally private businesses – are required to validate you (several pieces of ID) and often limit how much you can transfer from a fiat account. I found Coinbase.com relatively easy – all you need is a credit card and you can do a $250 purchase (but only once a week). They may or may not ask for ID. One that makes buying easy with a credit card (for a 10% fee) is Vancouver-based einstein.exchange. Use bank transfers is laborious. However, before you can send the coins anywhere you have to endure a complicated 4-step identification exercise. Mine took many days. On Jan 3, their website said they couldn’t handle new accounts and then later their website went down for maintenance. In the meantime, the currency could have dropped in value. Then, if and when you do acquire coins there is the hassle of keeping track of them. At least with a conventional bank, you can login to your account and see what you have. With a cryptocurrency website, you can do that too, but can you really rely on them? Most of them don’t give you your Private Key. Therefore, you’d be safer if you transfer your coins right away to a desktop wallet and keeping it off-line.

The value of a cryptocurrency is that it can be used to make fast international, totally anonymous transactions. Ideally, you should be able to convert USD$1,000 to Bitcoin, transfer it to someone who well then convert the bitcoin back to USD$1,000 (or the equivalent in Yen, Euros or whatever). What’s been happening, though, is that because many people are buying Bitcoin (with few sellers), the receiver of my US$1,000 is actually getting, say $USD1,100 in value. So, why hurry to exchange it?

A few years ago, you could walk into a WAVES Coffee shop in Vancouver, put a few hundred dollar bills into a machine (like an ATM) which would give you a piece of paper with an address and key (for convenience, this could be in the form of a QR Code that could easily be scanned later). You could then buy a coffee at WAVES by transferring some Bitcoin from your address (on that piece of paper) to WAVE’s address. You don’t even need to know WAVES address – you could simply transfer the payment for the coffee to a new address and give WAVES the address along with the key. However, if you go to WAVES a few days later and the Bitcoin has increased in value (relative to the dollar), you’d be better off paying in dollars and keeping your Bitcoin. As a further illustration, if you put $100 cash into a Bitcoin ATM a year ago, you’d have received a small QR-coded receipt. Taking this receipt to the ATM today would produce a cash payout of over $2,000 – all totally anonymous. I bought some Bitcoin a few years ago but the receipt faded and I could no longer read the address info. Normally, I would be out of luck but fortunately I took a photo of the receipt. This way, I could send the coin stored at the address on the receipt to myself at another address or to someone else.

So, the whole idea of simple transactions has gone out the window in favour of hoarding Bitcoins for future gains. The fact that only 21 million will ever be issued creates a climate of scarcity and hence, speculation. There are moves afoot to address this by defining cryptocurrencies known as tethers (see www.tether.to) that preserve a one-to-one exchange ratio with a fiat currency. However, there would still remain the issue of converting via an exchange and there’d need to be widespread global adoption. You could load up on such a currency and use it to send/receive value easily, cheaply and globally. You may never need to worry about exchanging it back if it were to become mainstream.

You may have heard about “forks”. A fork occurs in a blockchain when two blocks are added to the end of the chain resulting in a split in the chain. This results in two chains that are identical up to the point of splitting and then differ thereafter. This happened with Bitcoin in August 2017. It occurred because the software developers contributing to the evolution of blockchain software have differing opinions about its features and standards (e.g. size of blocks). One fork created Bitcoin Cash (BCH) at block 478,558. All holders of Bitcoin prior to the fork are now holders of Bitcoin and Bitcoin Cash. These now trade independently and both have their conversion-to-dollar rates. Some established exchanges may not even handle trading in the new currency.

To complicate matters further, within days of Bitcoin Cash being created, another fork created Bitcoin Gold (BTG) at block 491,407 on the original chain ostensibly to reduce the influence that miners have over the direction of the Bitcoin network thus making it easier for smaller miners. Everyone who owned Bitcoin before the fork now owns Bitcoin and Bitcoin Gold. Where will this end? So much for “open” standards!

And then there’s the concept of tokens and Initial Coin Offerings (ICO) as a method used by companies (not necessarily in the cryptocurrency business) to use the public’s appetite for cryptocurrency speculation to raise capital for conventional projects such as products or services as distinct from buying shares in a business. These newly minted coins or tokens can use their own blockchain or use an existing blockchain. Ethereum is a blockchain organization that facilitates the creation of not only its own cryptocurrency, Ether, but can also host other coins. Some newcomers that cater especially to people who want more anonymity are Zcash and Monero. Zcash is another fork off the Bitcoin blockchain. A new one that is getting a good response is Ripple (XRP).

All of this makes it very confusing for the non-technical person. Which cryptocurrency to buy (that is speculate)? How and where do I keep my coins? Which wallet should I use? Which websites can I trust? Which sources of information are accurate and reliable?

Aside from cryptocurrencies– and this is perhaps the most important aspect of blockchain – the blockchain technology itself continues to evolve as a software platform for tracking assets. For example, Walmart is looking at tracking grocery products to ensure quality and authenticity. Another example is the World Wildlife Fund which piloted blockchain in a tuna fishery in Fiji.

Blockchain holds the promise of providing a decentralized method of recording transactions involving all types of assets – real assets – not just mediums of exchange. Therein lies the excitement and boundless future applications in business and commerce!